The wild popularity of 130/30 funds notwithstanding, recent analysis of the unique long-short strategy suggests that advisers would be wise to check under the hood for a closer look at the portfolio and not just jump in to the latest marketing craze.
"Some of these strategies are taking on a lot of risk for the returns they're generating," said Steve Deutsch, director of separate and collective trusts at Morningstar Inc. of Chicago.
According to Mr. Deutsch, a growing appetite for alternatives to plain-vanilla long-only investment strategies has fueled a stampede into the space by the financial services industry.
A recent forecast has projected that assets in the strategy, also known as short-extension and leveraged-net-long, will swell from around $100 billion today to $2 trillion by 2010, according to research from the Tabb Group LLC of New York.
There are already 90 money management firms offering more than 200 products applying the short-extension strategy, according to Morningstar Inc. of Chicago.
The strategy is being applied to mutual funds, hedge funds, exchange traded notes, exchange traded funds, separately managed accounts and collective trusts for both individual and institutional investors.
For financial advisers and their clients, the challenge will be sifting through the heap of new products that all claim to have mastered the balance of leverage and short selling inside a single portfolio.
"It seems like the 130/30 name has become the latest buzzword and it is becoming a stamp of approval," said Tom Samuels, manager of a long-short strategy at Palantir Capital Management Ltd. in Houston.
The basic strategy, which has been building momentum for almost five years, is a twist on the long-short hedge fund strategy that has been around for more than 50 years.
The idea behind a short-extension strategy is to short-sell a percentage of a portfolio and apply the same percentage to leverage on the long side, thus maintaining a 100% net long exposure.
Applied to an index such as the Standard & Poor's 500 stock index, the strategy would enable a manager to sell short those stocks he least favored while leveraging long his favorite stocks in the index.
In theory, the strategy, which can be applied to both stock and bond portfolios, is expected to outperform a designated benchmark on a risk-adjusted basis.
In practice, however, the strategy demonstrates that traditional long-only money managers don't always excel at selling stocks short.
A key element of the strategy is to reduce risk, as measured by beta, in comparison with a designated benchmark.
In analyzing the returns of 40 different 130/30 strategies over the 12-month period through June 30, Mr. Deutsch found a beta range from 3.5 to a negative 1.25. A beta of 1 is considered to be subject to risk equal to that of the benchmark.
Mr. Deutsch found that 29 strategies were below that mark and 11 were above the benchmark beta.
In analyzing the respective portfolios, he found that managers were using a wide range of strategies and in some cases taking on additional risk to increase performance.
"In some cases, investors are probably getting more risk or less return than they bargained for," Mr. Deutsch said, though he added that most investors only focus on return.
Keeping the portfolio's beta in line with the benchmark is at the foundation of making the strategy work, according to Harindra de Silva, president of Analytic Investors Inc., a Los Angeles-based money management firm that is often credited with developing the short-extension strategy.
The firm manages $11.5 billion.
The fact that some money managers are now migrating toward ratios of 140/40 and even 150/50 doesn't bother Mr. de Silva, who insists that the ratios are irrelevant as long as the beta is held close to 1.TRACKING ERROR, RISK
"The ratio will vary over time, but we say, 'just focus on the tracking error and the risk and don't worry about the ratios,'" he said.
Risk, however, can be amplified, depending on the short-selling expertise of each money manager. "A lot of people starting these strategies don't realize that when you short something and are wrong, that position just gets larger," Mr. del Silva said.
Meanwhile, the market continues to move in the direction of 130/30 strategies, with growing supply meeting growing demand.
"We see a lot of traditional money management firms launching 130/30 strategies and we see these funds grabbing a larger share of the long-only assets already under management," said Adam Sussman, director of research at Tabb Group.
However, Mr. Deutsch is among those who worry that the strategy is becoming an investment fad tied largely to an interesting label.
"We think the 130/30 strategy is just the latest is a long line of products that have grown due primarily to competition," he said.
E-mail Jeff Benjamin at [email protected].
